The P/E ratio and P/B ratio are widely used financial metrics for analyzing a company’s valuation. Both the ratios are relative valuation metrics that help one understand the company’s financial health compared to its peers and the industry. P/E ratio is a ratio of a company’s stock price to its Earnings Per Share (EPS). While the P/B ratio is the ratio of the company’s market capitalization to its book value.
What is P/E Ratio?
The Price Earnings Ratio (P/E ratio) compares the current stock price of a company to its Earnings Per Share (EPS). It is a valuation ratio that helps investors analyze if a stock is undervalued or overvalued.
Earnings are important while evaluating a company, as this shows the current profitability and also helps in estimating the company’s future profitability. Furthermore, in case the company’s growth is slow and the earnings are constant, the P/E can be considered as the number of years it takes the company to pay back the price paid for each share.
P/E Ratio = Market Price of the Stock/ Earnings Per Share
Interpretation of P/E Ratio
P/E ratio depicts whether you are paying a fair price for the company’s stock. Return on Investments (ROI) is the primary objective for every investor. This financial ratio helps in comparing the companies belonging to the same sector, regardless of their prices.
P/E ratio is the quickest and easy way to value a company using earnings. Based on the P/E ratio, it is easy to assess what kind of company it is.
Companies that have a high P/E ratio can be considered as growth stocks. A high P/E ratio can indicate a positive future performance, and investors can expect earnings growth. On the contrary, growth stocks are highly volatile. As a result, the companies are under pressure to perform better to justify their valuations. Therefore, a high P/E stock can be a risky investment and sometimes be considered overvalued.
Companies that have a low P/E ratio can be considered value stocks. In other words, these can be stocks that are undervalued – trading at a lower price to its fundamentals. The difference between the two can be a great bargain for the investors. It is a good indication for the investor to buy the stock before that market corrects it. Upon correction, the investor may benefit from a higher stock price (price appreciation). Low P/E stocks often belong to mature industries that pay a steady rate of dividends.
The justified P/E is different from the standard P/E ratio. As a result, the two ratios are different. If the P/E ratio is lower than the justified P/E ratio, then the company is undervalued. Such stocks have the potential to generate profits over time.
Justified P/E = Dividend Pay-out Ratio / R – G
R – Required rate of return
G – Growth Rate
It is important to note that you cannot consider the P/E ratio in isolation to analyze a company’s financial health. There are many other valuation techniques that have to be taken into consideration as well.
A company with negative earnings will have a negative P/E ratio. Some companies can face negative cash flows due to reasons that are beyond their control. Stay away from companies that have a negative P/E ratio consistently. Such companies can go bankrupt at any time. Certain companies do not disclose their EPS for some quarters, and this can be a way to avoid showing negative P/E.
What is P/B Ratio?
The Price to Book (P/B) Ratio compares the company’s current market value to its book value. The market value is the current stock price of all the outstanding shares.
While the book value is the amount left after liquidating all the assets and repaying all the company’s liabilities, the book value of a company is derived from the balance sheet. This financial valuation ratio depicts the pricing of the company’s equity in accordance with the market.
In other words, it shows the market’s perception of the stock’s value. Most commonly, the P/B ratio is used to value real estate, financial, insurance companies and investment trusts. For companies asset-light, such as the technology sector, the P/B valuation doesn’t work well.
P/B ratio denotes how much the equity investors are paying for each rupee in net assets.
P/B ratio = Market Capitalization / Net Book Value
Net Book Value = Total Assets – Total Liabilities
Interpretation of P/B Ratio
Similar to the P/E ratio, P/B is a highly useful metric that helps compare the valuation of one company with its peers. However, you shouldn’t consider this valuation ratio in isolation. It is advisable to consider other valuation parameters as well.
- High P/B Ratio: A high P/B ratio indicates that the company’s stock is expensive.
- Low P/B Ratio: A low P/B ratio indicates that the company is undervalued.
P/B ratio is a relative valuation metric, and therefore, it cannot be considered independently. Always compare the P/B of a company to its industry P/B and also with its peers. Such relative valuation will help you understand whether the stock under consideration is undervalued or overvalued.
Difference Between P/E Ratio and P/B Ratio
Following are the key differences between P/E Ratio and P/B Ratio:
|Basis of Difference||P/E Ratio||P/B Ratio|
|Meaning||Compares the company’s current market price to its earnings per share.||Compares the company’s current market value to its book value.|
|Formula||Market Price of the Stock/ Earnings Per Share||Market Capitalization / Net Book Value|
|Inference||It depicts the number of years it takes the company to pay back the price paid for each share.||Depicts the pricing of the company’s equity in accordance with the market.|
P/E Ratio vs P/B Ratio Which is More Relevant for Banks in India?
The P/B ratio is the widely used valuation ratio for valuing banking and financial services companies. Following are some of the reasons why P/B is a more preferred ratio than P/E:
All banking firms follow a similar trend towards macroeconomic conditions like interest rates (RBI), inflation, etc. To understand which bank is performing better, it is essential to understand how efficiently they utilize the assets or funds. P/E ratio represents the market value of the stock to its earnings. While P/B ratio helps you assess the company by considering the market capitalization to its book value. As a result, you can understand how efficiently the company has utilized the funds. For banks, optimal utilization of funds plays an important role while valuing it.
Bank spread is a good indicator while comparing the performance of a bank. The cost of funds and the yield is more or less the same for many banks. As a result, the P/B Ratio is determined based on the bank’s spread and its capacity to control non-performing assets (NPAs). In accordance with Basel rules, banks must also maintain a specified capital adequacy ratio, which is a percentage of their assets. Since the P/B ratio is also based on the book value (total assets – total liabilities), it’s a good indicator.
Better Picture of the Company
The P/E ratio doesn’t make sense for a loss-making company. In other words, a company with no earnings P/E ratio doesn’t depict an accurate valuation. For instance, a loss-making bank can be profitable by creating favourable conditions to maintain the spread. Also, banks often have long investment and gestation periods. As a result, P/B is a more favourable ratio to analyze a bank’s performance.
P/B ratio is a basic valuation metric, depending on its value in isolation may not lead to an accurate analysis. P/B, along with Return on Equity (ROE), can lead to a more effective analysis. Both in conjunction will provide a better insight into the bank’s growth prospects. Furthermore, a positive correlation between ROE and P/B is a good indicator of a strong company.
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